Examples of Return on Equity
The following Return on Equity example
Formula
The ROE formula is given below
Calculation Examples of Return on Equity
Example #1 – Basic Return on Equity Calculation
Consider the following example of 2 companies having the same net income but however different components of shareholder’s equity.
The ROE arrived after applying the formula are given as under
If one were to notice we can see that the net income earned by the companies are the same. However, they differ with regard to the equity component.
Hence by looking at the example, we can understand that a higher ROE is always preferred as it indicates efficiency from the side of the management in generating higher profits from the given amount of capital.
Example #2 – ROE Calculation using Average Shareholder’s Equity
Consider the following details.
Mr. Smith runs an FMCG distribution business called Smith and Sons. A few financial details of the company are given as under. Calculate the ROE.
Solution:
The net income for the period is arrived by deducting the expenses from income
4.9 (1,067 ratings)
($36000-$25500=$10500)
Net worth or the equity component of a company is arrived at by deducting the liabilities from that of its total assets.
($58000-$39600=$18400)
In the question, information about beginning shareholder’s equity is provided and hence it is common practice to take the average of the same as any income generated is done so by utilizing the past investments. Hence the average shareholder’s equity comes up to $19200 (Average of $18400 and $20000).
Hence the final ROE given by net income/Shareholder’ equity amounts to 54.69% ($10500/$19200).
Example #3 – Peer Comparison of ROEs
As a part of financial statement analysis, ROE is used as a profitability measure by comparing the same across similar companies and then ascertaining if it is within the ballpark range of that of the industry.
Consider the following example
The ROE of each of the company is calculated and is presented along with the industry average in the snapshot as below.
General Comments:
One can notice here that though the company LMN Co has lesser profit than that of ABC co, the ROE turned out to be better given its lower capital. Hence it is an indication that of all the 3 companies that LMN Co is most efficient in generating profitability to its shareholders.
And thus an analyst may as well consider LMN Co to invest as it has also beaten the industry average.
Example #4 – ROE & DuPont Analysis
A wide application of the ROE ratio is the DuPont analysis or the 5-factor model. This method refers to a decomposition of the ROE by expressing them into component ratios, thus helping us to carefully evaluate as to how different aspects of the performance of the company had its profitability affected.
It is named after, DuPont being the first company to develop the same. The breakdown of the formula is given as under.
Net Income/Average shareholder’s equity=
(Net income/EBT)*(EBT/EBIT)*(EBIT/Revenue)*(Revenue/Total assets)*(Total assets/ Average shareholder’s equity)
This can be interpreted as
ROE=Tax burden x Interest burden x EBIT margin x Total assets turnover x Leverage
Consider the following table. This relates to a break up of ROE of Fictional Co for 3 years
Analysis and Interpretation
ROE has decreased over the years. Let’s make an attempt to understand as to which component is causing this
- The tax burden has been somewhat consistent indicating that not much variation is caused by taxes
- Interest burden too has remained almost the same indicating that the company is maintaining a constant capital structure
- We notice that the EBIT margin or operating margins have decreased during the years. There is a possibility that operating expenses did increase over the years.
- Company’s efficiency (assets turnover ratio) too decreased over the years
- The leverage has also remained consistent in line with interest burden again evident by the constant capital structure that the company has maintained
Thus using a DuPont analysis an analyst will be in a good position to understand as to what exactly drives a company’s ROE given by the breakdown.
A 3-factor model is used which is given by
ROE= (Net profit/Sales)*(Sales/Assets)*(Assets/Shareholder’s equity)
Conclusion
Using the various examples, we saw how a metric such as Return on Equity can be used to assess the performance or profitability of a company. This metric serves as the right measure as a decision criteria in having to choose between companies to invest/buy along with certain other ratios too, that analysts use as a part of financial statement analysis.
Recommended Articles
This has been a guide to Return on Equity Examples. Here we discuss the step by step calculation of ROE along with basic and advanced examples and explanations. You can learn more financial analysis from the following articles –
